Friday, December 05, 2014

Law, Economics, and Posner

by Michael Dorf
On the Concurring Opinions blog, Ron Collins has been running a fascinating series on and with Judge Dick Posner. You can find the first three installments here, here, and here. The fourth installment consists of questions from judges, a journalist, and a whole bunch of law professors, including me. I recommend the whole series but here I'll focus on the answer Posner gave to one of my questions. (Each of the 24 interviewers submitted two questions to Collins, who asked them of Posner.)

Me: I detect in your academic work (and to a lesser extent your work as a judge) a gradual drift from an economic analysis of law to pragmatism more broadly. Do you agree with that assessment, and if so, what do you think accounts for it?

Judge Posner: You’re correct. It is partly a result of the inroads that psychology has made on economic analysis, partly a result of the economic profession’s failure to understand finance and monetary policy in the period leading up to the crash of 2008, and (relatedly) the revelations of unexpected extensive greed and corruption in American business, not limited to the financial industry.

Let's unpack the judge's answer in four pieces.

(1) Judge Posner agrees that he has become less enamored of Law & Econ over time, while drifting towards pragmatism more broadly. I don't regard this as a great insight on my part. Both pieces of the shift are pretty obvious from Posner's work. Indeed, in an answer to a different question from Fred Schauer about what Posner thinks of jurisprudence, he says: "I love the legal realists, above all Holmes, but also John Dewey, Jeremy Bentham, of course, Hans Kelsen, and Richard Rorty." Holmes, Dewey, and Rorty are expressly identifiable as pragmatists, Bentham is the father of utilitarianism, which has a close relationship to pragmatism, and only Kelsen can be seen as not a pragmatist--but Kelsen was what would today be called a "hard" or "exclusive" legal positivist, committed to the separation of law and morality. As such, his views are conducive to pragmatism: Because hard positivists tend to think that the law runs out at a point before Fullerians/Dworkinians think the law runs out, a hard positivist will more often think that the law is indeterminate and thus open the way for pragmatic considerations--and that is in fact Posner's view.

(2) Posner cites the inroads of psychology as one reason for his diminished interest in economic analysis of law. Presumably, he has in mind the mountain of evidence from psychology that real people are not consistently rational wealth maximizers or even utility maximizers. They are driven by all sorts of other goals, cognitive distortions, prejudices, etc.--some conscious and some unconscious. But Posner's response was by no means pre-ordained.

Posner might have abandoned rationality as a necessary criterion of economic analysis of law and joined the ranks of "behavioral" economists who relax the rationality assumption where psychology (or common sense) indicates that people are not perfectly rational. But for the most part, Posner doesn't do that. Instead, he has defended conventional economics against behavioral economics.

The most common way in which conventional economics defends itself against the charge that people aren't rational is by saying that it doesn't matter: Using a model in which we assume that people are rational actors produces useful predictions anyway, they say. There are micro-explanations for this sort of phenomenon. E.g., suppose that 90% of grocery shoppers don't comparison shop, but not because they value their time more highly than the expected utility of cheaper groceries; suppose they act this way simply because they're not rational; they are irrationally loyal to one or another store, let's say. Nonetheless, the 10% who do comparison shop will exert sufficient pressure to keep prices competitive (which makes not comparison shopping rational after all). That's a pretty good story but the general form of the response doesn't depend on the ability of economists to come up with stories of this sort. Instead, it's usually just a naked claim that rationality is an assumption of the model and the model works well.

Notably, however, Posner's main response to behavioral economics has been different. He defends conventional economics, e.g., in this 1998 Stanford Law Review article, by arguing that conventional economics does not in fact assume anything like perfect rationality, and by questioning whether behavioral economics really is a distinctive field. Posner repeated that move in a short 2013 paper on behavioral financial economics. There he said (correctly) that in a financial market with rational actors, we would not see bubbles, because the smart money would very quickly go short in an overvalued financial market, which would bring the financial market in line with the fundamentals of the real economy. The "conventional" economist on whom Posner most heavily relies to show that this insight does not depend on the newfangled behavioralism is . . . wait for it . . . Keynes.

(3) That brings us to Posner's second stated reason for losing (some) faith in economics: the failure of economists to understand finance and monetary policy leading to the 2008 crisis. But wait a minute. There was one branch of economics that understood exactly what the problem was--namely Keynesian macroeconomics. Indeed, as Professor Buchanan (on this blog and elsewhere), Paul Krugman, and depressingly few others have been saying for the last 6+ years, most economists still are clueless for their failure to grasp the Keynesian insight that in a period in which the economy has substantial unused capacity, worries about the inflationary effect of easy money policies are profoundly misguided. And Posner knows it, as indicated by his wonderful New Republic essay in the wake of the crisis, aptly called How I Became a Keynesian.

So why does Posner say that I am right that he has moved away from the economic analysis of law and towards pragmatism more generally, rather than saying something like "I still believe in the economic analysis of law but I think it should be Keynesian rather than orthodox neoclassical economic analysis"? The answer, I think, is that while Keynesianism is enormously important to the formulation of good economic policy and law at the large scale, it is rarely relevant to the sort of work that judges do. "Law and economics" has almost always meant "law and microeconomics," which makes sense if we're trying to figure out the incentive effects of one or another rule (negligence versus strict liablity, say) on individual actors. So the kind of economics for which a judge might have a need is going to be micro, but Posner finds Keynes useful for what Keynes says about macro. No one has restored his faith in orthodox microeconomics, so as a judge he remains fairly disillusioned about economics.

(4) Finally, I'll add that Posner's last reason for moving away from law & econ is not mere sentimentality. He cites "the revelations of unexpected extensive greed and corruption in American business, not limited to the financial industry." At first blush, this seems naive. Why would greed be unexpected in business? Isn't the whole point of capitalism supposed to be that it harnesses selfish behavior for the greater good? In a word, no. Posner's statement reveals that he was always more sophisticated about markets than we may have realized. He understood--with Adam Smith, among others--that free market exchanges can only be built on a foundation of virtue, that in a world without trust, there cannot be free exchange, and that conversely, a market dominated by Holmesian bad men will produce bad results. Looking at the law from the perspective of a bad man (as Holmes advises) means that markets need to be regulated. In the end, this insight from Posner's hero leads him away from the version of law & econ that he once preached.

13 comments:

Posner talks about the failure of economics on a pre-2008 basis. The Keynesians including Mr. Krugman and Mr. Buchanan among many others largely address economic policy on a post 2008 basis. There is a profound difference here, one that Mr. Dorf alludes to in his last statements.

The failure of economics with respect to the 2008 crisis is not a failure of macro-economic policy. The 2008 crisis was not the result of bad macro-economic policy; it was the result of bad, absent and corrupt regulatory policy. This policy was initiated in the 1990’s under the belief that financial markets could be de-regulated and continued into the 2000’s with an abdication of regulatory oversight that ultimately led to the 2008 near total collapse of domestic and world wide financial systems. Neither monetary policy nor fiscal policy was a significant factor, the calamity was the result of actions of nearly unlimited greed on the part of individuals and institutions abetted by government refusal to regulate. Need further evidence, look at how Canada survived the housing/mortgage/financial crisis.

The failure of economics with respect to the response to the 2008 crisis was indeed a failure of macro economic policy. The collapse of Aggregate Demand and the entry of the monetary system into the Liquidity Trap called for Keynesian stimulus. In the US the policy response was present, but very weak, misguided and misdirected, and so the recovery was much weaker than it needed to be. In Europe the rejection of stimulus and its replacement with the absurd policies of fiscal restraint and austerity resulted in an economic catastrophe.

In neither the pre-2008 period nor the post 2008 period were progressive economics and progressive economists to blame. The abandonment of regulation and oversight of the financial sector produced what it always produces, a Panic, a Depression, a Recession or whatever you want to call it. The abandonment or weakening of Keynesian fiscal policy produced what it always produces, a weak, prolonged or non-existent recovery. The fault, Mr. Dorf and others, is not in the stars but in ourselves that we are weak and afraid and suffered economic disaster.

I don't disagree with DR's astute distinction between pre-and post-2008 policy. I would add one quibble, though. There is at least a plausible case to be made that monetary policy was partly to blame for the crisis: The Fed under Greenspan and the early-period Bernanke kept interest rates too low too long, contributing to the financial bubble. Of course, the extravagant and dangerous use that was made of low interest rates was possible because of regulatory failure, which, I agree, was the main culprit.

Thanks, Mike, very interesting reflections. For what it is worth, I think that one way that the judge could could describe the failure of many orthodox economist prior to 2008 is as having failed fully to understand the logical consequences of their own orthodox commitments themselves. What happened during this period was perfectly consistent with markets' informational efficiency and market actors' (orthodox) rationality. The problem was that certain kinds of information were missing, and individually rational actions against that backdrop readily aggregate into collectively irrational outcomes. So I argued here at DoL on the occasion of the judge's lovely New Republic essay: http://www.dorfonlaw.org/2009/09/what-maynard-keynes-james-dean-and-now.html

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